Arbitrage Pricing Theory

Lorenzo Bretscher

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Reminder: Arbitrage

An asset with price equal to zero and (PV of) E[future CF] > 0!

An asset with a price different from zero and all future CF are equal to zero.

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Factor Pricing and Arbitrage Pricing Theory

The central prediction of the CAPM is that

ERie = βim Rm
e

where βim is asset i’s market beta, cov (Ri , Rm ) / var Rm

We can also run the regression
e e
Ri,t = αi + βim Rm,t + εit (1)

as a purely statistical exercise

Suppose we did so, and suppose that we found the errors εit were
uncorrelated across stocks: E [εit εjt ] = 0 for all i 6= j and t
2
Covariances would be easy to estimate because cov (Rit , Rjt ) = βim βjm σm

, so
2
we only have to estimate N betas with the market rather than N − N /2
covariances
If N is large, we should expect αi typically to be very small
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Factor Pricing and Arbitrage Pricing Theory

A portfolio of N assets with weights wj will have the return

e e
Rpt = αp + βpm Rmt + εpt
PN PN PN
αp = j=1 wj αj , βpm = j=1 wj βjm , and εpt = j=1 wj εjt
The variance of the portfolio residual error is
N
X
var εpt = wj2 var εjt
j=1

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Factor Pricing and Arbitrage Pricing Theory

This variance is very small for large N. Suppose that the maximum
idiosyncratic variance of any asset j is σ 2 , and that we choose to equally
weight the portfolio (wj = 1/N). Then

σ2
var εpt ≤
N
As N → ∞ this goes to zero: the portfolio is well diversified
So we can ignore εpt , and we have
e e
Rpt = αp + βpm Rmt

But then we must have αp = 0 : If αp > 0, we could go long portfolio p and

short the market, earning αp without taking any risk or putting up any
money up front
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Factor Pricing and Arbitrage Pricing Theory

This is the arbitrage pricing theory (APT) of Ross (1976): if excess returns
e
can be explained by a market factor Rm,t as in (1), with uncorrelated
residuals, then
e e
ERi,t = βim ERm,t
We have derived the beta pricing equation of the CAPM without using any of
the apparatus of mean-variance analysis
The key assumption is that the residual risks εit are uncorrelated (still!)

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Anectodal Empirical Evidence

CAPM (or any one-factor model):

Ri − Rf = αi + βim [Rm − Rf ] + εi

Is it realistic to assume that ε̃i ’s are independent?

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Advance Micro Devices vs. Intel

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AMD vs. INTC
Do CAPM regression for AMD/INTC
AMD: σ = 3.8%, βSPY = 1.42
INTC: σ = 2.0%, βSPY = 1.02
Correlation between εAM and εINTC is 0.2

Maybe, indeed a better model of risk and return is needed!

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Factor Pricing and Arbitrage Pricing Theory

The "market" can be any broadly diversified portfolio that produces

uncorrelated residual risk
In practice, no single factor accounts for all the correlations between asset
returns
I Industry effects
I Macroeconomic variables
I Small firms seem to move together

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Factor Pricing and Arbitrage Pricing Theory

If there are K portfolios capturing the influence of K underlying common

sources of risk, such that the regression
K
X
Rite = αi + e
βik Rkt + εit
k=1

delivers uncorrelated residuals, then the prediction of the model is that αi

should be very close to zero for almost all stocks
We want K  N− why?

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Factor Pricing and Arbitrage Pricing Theory

Ways to pick factors for multifactor models:

I The first factor is normally an excess return on a broad market index
I You can do principal component analysis to find the most important common
factors. Unfortunately, you tend to find more and more factors as you increase
the number of assets
I Macro factors (inflation, interest rates, industrial production)
I Portfolios of stocks with common characteristics (size, book-to-market,
momentum). This leads to a data-snooping problem if the characteristics are
chosen to produce high average returns in sample
I Factors suggested by equilibrium models, for example innovations in variables
that predict market returns

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Factor Pricing and Arbitrage Pricing Theory

The strength of the APT is the minimality of its assumptions

But this is also a weakness
I Some portfolio is always ex post mean-variance efficient. So we can always
find some 1 -factor model that fits the data. What does this tell us about the
world?
I The theory does not determine the signs or magnitudes of risk prices. Much
recent work on general equilibrium asset pricing seeks to pin down risk prices
more precisely based on theoretical considerations

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Factors are Useful for Hedging

Consider Barrick Gold (ABX), a gold mining firm

Assume a factor model such as the following, where the factors are the
market (SPY) and the price of gold (GLD)

r˜abx − rf = αabx + βSPY [˜

rSPY − rf ] + βGLD [˜
rGLD − rf ] + ε̃abx

If you form a portfolio with the same βSPY and βGLD , then you track
Barrick’s exposure to these common factors. It’s like replication with factors.
You can track exposure to both factors or exposure to just one (e.g., GLD)

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Factors are Useful for Hedging

You want to buy Barrick Gold (ABX), but you want to hedge out the exposure to
the price of gold

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Factors are Useful for Hedging

Regress returns of ABX on two factors: SPY and GLD (a gold ETF)

r˜abx − rf = 0.00 + 0.45 × [˜

rSPY − rf ] + 1.62 × [˜
rGLD − rf ] + ε̃abx

The portfolio that tracks the GLD exposure has βGLD = 1.62:
I wGLD = 1.62 and wrF = −0.62
I r˜track = wGLD r˜GLD + wrf rf = 1.62 × r˜GLD + (−0.62) × rf = rf + 1.62 × [˜
rGLD − rf ]
The tracking portfolio has βGLD = 1.62
So to hedge out the GLD exposure, short $ 1.62 of GLD for every $ 1
invested in ABX and invest $ 0.62 in the risk-free bond

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Factors are Useful for Hedging

Now imagine a portfolio that tracks BOTH SPY and GLD exposure
I wGLD = 1.62, wSPY = 0.45and wrF = 1 − (0.62 + 0.45) = −1.07
What is the return of a portfolio long Barrick Gold and short the tracking
portfolio?
r˜hedge = r˜abx − r˜track = αabx + ε̃abx
Let’s assume ε = 0. In reality, they are not, but let’s assume this for a
moment → r˜hedge = αabx + ε̃abx = αabx
If epsilons are always zero, then we have a zero cost portfolio with certain
returns → what should the return be?

αabx = 0

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Factors are Useful for Hedging

If we have a factor model, we can create a tracking portfolio

If there is no idiosyncratic risk, then we’ve replicated the security and we can
write down the return equation:

r˜abx = rf + 0.45 × [˜
rSPY − rf ] + 1.62 × [˜
rGLD − rf ]

This is the idea behind the Arbitrage Pricing Theory (APT)!

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